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CAPITAL GAINS STRUCTURING

CAPITAL GAINS
Capital Gains Tax under the Income Tax Act is tax payable on the transfer of a
capital asset situated in India. Capital Assets according to the Income Tax Act, 1961
is property of any kind held by an assessee, whether or not connected with his
business or profession. The transfer of capital asset must be made in the previous
year. This is taxable under the head Capital Gains and there must exist a capital
asset, transfer of the capital asset and profit or gains arising from the transfer. That is a
person is taxable on the profits and gains derived from the transfer of a capital asset.
Capital gains tax in India is payable at different rates depending on the holding period
of the capital asset.
Capital assets held for more than 36 months are considered as long-term capital
assets. Shares held for more than 12 months are considered long-term capital assets.
The 12-month holding period applies only to specific securities, including shares in a
Company. Other kinds of securities such as debentures, options, or bonds must be
held for more than 36 months to qualify for the long-term capital gains tax rates.
Long-term capital gains are generally taxable at 20% and short-term capital gains at
30%.
Indexation benefits are available to Indian residents on long-term capital gains except
where the long-term capital asset is a bond or debenture other than capital indexed
bonds issued by the government. Short term capital losses can be offset against shortterm and long-term capital gains, while long-term capital losses can only be offset
against long-term capital gains. Further, capital gains tax is payable in the tax year in
which the capital asset is transferred, regardless of the year in which consideration is
actually received.
As per Section 2 (47) of the Income Tax Act for a transfer to be treated as a capital
gain the previous owner must relinquish all the rights on the said property. If the
property is used as a share it will be regarded as a capital gain as well. Further,
according to Section 9 (1)(i) of the Act income accruing indirectly or directly out of
transfer of Capital Assets situated in India is deemed to accrue in India out of the hand
of a Non-Resident.
CORPORATE STRUCTURING (M&A)
Amalgamation is a merger of one or more companies with another company or that of
two or more companies to form one company. All the property and liabilities of the

CAPITAL GAINS STRUCTURING


amalgamating companies immediately before the amalgamation becomes the property
of the amalgamated company. Shareholders holding not less than 75% in value of the
shares in the amalgamating companies become shareholders of the amalgamated
company.
An amalgamation may give rise to tax on capital gains on the disposal of the shares by
the shareholder. The acquisition of the business of an Indian company can be
accomplished by the purchase of shares or the purchase of all or some of the assets.
From a tax perspective all gains on sales of assets are taxable, except for long-term
capital gains arising on a sale of equity shares through the recognized stock exchanges
in India.
However, under the Income Tax Act 1961, transfer of a capital asset through a scheme
of amalgamation is not considered as a transfer for the purpose of capital gains in the
following cases:

Capital gains tax exemption for the amalgamating company: Any transfer
of a capital asset by the amalgamating company to an Indian amalgamated

company is exempt.
Capital gains tax exemption for the shareholders of an amalgamating
company: Under an amalgamation scheme, the amalgamating company
shareholders receive shares in the amalgamated company in exchange of
shares of the amalgamating company. A transfer by such a shareholder, where
the capital asset is shares in the amalgamating company, is exempt from
capital gains tax, provided the transfer is made in consideration for allotment
of shares in the amalgamated company to such shareholder and the
amalgamating company is an Indian company. Therefore, if the shareholders
receive consideration other than shares, the gains are subject to capital gains
tax.
Capital gains tax exemption for a foreign amalgamating company: A
transfer of capital asset by a foreign amalgamating company to the foreign
amalgamated company, where the capital asset is shares in an Indian company
is exempt from capital gains tax, provided: at least 25% of the shareholders of
the foreign amalgamating company continue to remain shareholders in the
amalgamated company; the transfer does not attract tax on capital gains in the
country in which the amalgamating company is incorporated.

CAPITAL GAINS STRUCTURING


SHARE ACQUISITIONS AND DISPOSAL
Businesses can be acquired through purchase of shares. No deduction is allowed for a
difference between the underlying net asset values and the consideration paid. Further,
the sale of shares is taxed as capital gains to the seller. An acquirer (being individual,
firm or a company) paying less than fair market value for acquisition of shares in an
Indian company is also subject to tax in India. The tax is levied on the difference
between fair market value and purchase price of the shares. This however does not
apply to publicly listed companies and some types of mergers and demergers. The tax
is only triggered in case of transfers when the difference between the fair market
value and the transfer price is greater than INR 50,000. Capital gains earned by a nonresident are considered to have their source in India and are taxable in India if they
arise directly or indirectly, through the transfer of a capital asset situated in India. The
rate of tax on capital gains earned by a non-resident varies from 0% to 40%
depending on the type of asset, period of holding and special status of the nonresident (for example, foreign institutional investors (FIIs) registered with the
Securities and Exchange Board of India receive a preferential capital gains rate under
certain circumstances.
Therefore, in a transfer of shares of an Indian company, the transferor is taxable in
India, unless the transferor is a resident of a country with which India has a favourable
DTAA such as Mauritius or Singapore. Foreign companies are not entitled to
indexation benefits on shares and debentures as the applicable forex rate already
factor into inflation.Further, any gains arising from the transfer of shares or
debentures are calculated by converting the cost of acquisition, expenditure incurred
and the value of consideration received into the same foreign currency as used to buy
the asset. The capital gains are then converted into Indian currency for capital gains
tax calculation. If shares are acquired by a person at less than fair market value, the
acquirer may be taxed on the difference between the fair market value and the
consideration paid, at 30% for residents and 40% for non-residents. Shares are
generally considered as capital assets unless the shares are held as stock-in-trade,
giving rise to capital gains on disposal. The capital gains tax payable on the disposal
of shares is stamp duty which is payable on the share transfer form and the share
purchase agreement.
Tax is to be withheld by the buyer Any person responsible for making a payment to a
non-resident, which is chargeable to tax under the ITA, must withhold tax at the

CAPITAL GAINS STRUCTURING


applicable rates. If the capital gains earned by a non-resident from sale of shares in an
Indian company are taxable in India, there is a liability on the buyer (irrespective of
the buyers location) to withhold and deposit the tax with the Indian Government.
Failure to deduct tax could result in the buyer being considered as an assessee-indefault, and the buyer may be liable to pay interest and a penalty in addition to the
amount of tax in arrears. However, if the non-resident seller is located in a jurisdiction
with which India has a DTAA and India has given up its right to tax the capital gains,
there is no obligation on the buyer to withhold tax given the capital gains earned by
the seller are not chargeable to tax in India.
SHARE BUYBACKS
Capital gains on buyback Distributions made on the shares held in an Indian company,
are generally considered as dividends if paid from the accumulated profits of the
company. However for share buybacks, distributions have been specifically excluded
from the definition of dividends under the FA. Under the ITA where a shareholder
receives any consideration from the company for purchase of shares by the company,
the consideration is chargeable to tax in India as capital gains. The difference between
the consideration received from the company and the cost of acquisition of the shares
is the amount chargeable to tax as capital gains in the hands of the shareholders in the
year in which the shares were bought by the company.
ASSET ACQUISITIONS AND DISPOSALS
In an asset sale, there is a transfer of a capital asset, and therefore there is a capital
gains tax liability for the transferor to the extent of gains realized. Unless the transfer
falls under any of the exceptions, there is tax on capital gains at 20% (long-term
capital gain) and 30% (short-term capital gain). The asset should be held for more
than 36 months to be considered as a long-term capital asset. A purchase of assets can
be achieved through either a purchase of a business on going concern basis or a
purchase of individual assets. The acquisition of business could be one of two types: a
slump-sale or itemized sale basis. Both slump-sales and itemized sales are subject
to capital gains tax in the hands of the sellers.
Slump sale
A slump sale is the transfer of one or more undertakings through the sale for a lump
sum without values being assigned to individual assets and liabilities. Profits and
gains arising from the slump sale are taxed as long term capital gains if the

CAPITAL GAINS STRUCTURING


undertaking or undertakings have been held by the transferor for more than 36 months
before the date of transfer. With a holding period of less than 36 months, the capital
gains are treated as short term. For the purpose of capital gains calculation the cost of
acquisition and the cost of improvement of the undertaking or division is the net
worth of the undertaking or division. Net worth is the aggregate value of the total
assets of the undertaking or division as reduced by the liabilities of the undertaking or
division as appearing in its books of account. Further, for depreciable assets, the
written down value of the block assets is considered.
ITEMIZED SALE
Capital gains taxes arising on an itemized sale depend on the nature of assets, which
can be divided into three categories:

tangible capital assets


stock-in-trade
intangibles (e.g. goodwill, brand).

The tax implications of a transfer of capital assets depend on whether the assets are
eligible for depreciation under the Income Tax Act. For assets on which no
depreciation is allowed, consideration in excess of the cost of acquisition and
improvement is taxable as a capital gain.
For the purposes of calculating the inflation adjustment, the assets acquisition cost
can be the original purchase cost. Inflation adjustment is calculated on basis of
inflation indices prescribed by the government of India.
For assets on which depreciation has been allowed, the consideration is deducted from
the tax written-down value of the block of assets, resulting in a lower claim for tax
depreciation going forward. If the unamortized amount of the block of assets is less
than the consideration received or the block of assets ceases to exist (i.e. there are no
assets in the category), the difference is treated as a short-term capital gain. If all the
assets in a block of assets are transferred and the consideration is less than the
unamortized amount of the block of assets, the difference is treated as a short-term
capital loss.
Goodwill arises when the consideration paid is higher than the total fair value/cost of
the assets acquired. This arises only in situations of a slump-sale. Under the tax law,
only depreciation/amortization of intangible assets, such as knowhow, patents,
copyrights, trademarks, licenses and franchises or any similar business or commercial

CAPITAL GAINS STRUCTURING


rights, is permissible. Recent judicial precedents have allowed depreciation on
goodwill arising out of amalgamation by treating it as a depreciable asset.
Depreciation charged in the accounts is ignored for tax purposes. The tax laws
provide for specific depreciation rates for the tangible assets (buildings, machinery,
plant or furniture), depending on the nature of asset used in the business. Depreciation
is allowed on a block of assets basis. All assets of a similar nature are classified
under a single block and any additions/deletions are made directly in the block. The
depreciation rates apply on a reducing-balance basis on the entire block. However,
companies engaged in the generation and/or distribution of power have the option to
claim depreciation on a straight-line basis.
CAPITAL GAINS TAX PLANNING
The Vodafone case1 is a classic example of how corporates can structure their
transactions in a way to avoid capital gains tax on transfer of capital assets. In
Vodafone International Holdings BV v. Union of India2, Hutchinson International
(non-resident company) held 100% shares of CGP Investments Holdings Ltd. (nonresident company), which in turn held 67% shares in the Indian company HutchinsonEssar. Hutchinson-Essar was a joint venture between Hutchinson International and
Essar. Vodafone International Holdings BV (non-resident company) acquired the
entire share capital of CGP Investments Holdings Ltd. from Hutchison International.
This resulted in an indirect transfer of 67% shareholding in Hutchinson-Essar to
Vodafone.
The issue here was to determine whether the income accruing to Hutchinson as a
result of the transaction could be deemed to accrue or arise in India by virtue of 9 of
the Income Tax Act.
The Income Tax Department was of the view that the income that accrued to
Hutchinson as a result of the transaction which arose or accrued in India and hence
was liable to be taxed. The Income Tax Department issued Vodafone a show cause
notice asking why action should not be taken against it for failing to deduct tax at
source under 195 of the Income Tax Act, 1961while making payment of the
consideration to Hutch.

1Vodafone International Holdings BV [2012] 341 ITR 1 (SC)


2 Ibid

CAPITAL GAINS STRUCTURING


The High Court by its decision tried to lift the veil over the intermediary foreign
company, holding that the transfer of shares of the intermediary company in fact
amounted to the transfer of controlling interest in Hutchinson-Essar which is an
Indian company and hence liable to be taxed.
However, there are precedents that state corporates being separate legal entity has an
equal right to plan its taxes and according plan its transactions. The Advance Ruling
Authority ruled on the same lines in the case of E*Trade Mauritius Ltd 3. In this case
the applicant, a resident of Mauritius, was a subsidiary of a USA company. It received
capital contribution and loans from the USA parent, which were used to purchase
shares in ILFS, an Indian company. On the sale of shares, the applicant earned capital
gains, which were taxable under the Income Tax Act, 1961. However, under Article 13
(4) of the India-Mauritius tax treaty, such gains were not taxable in India.
The applicant filed an application for advance ruling on the question whether in view
of Article 13 (4), the gains were chargeable to tax in India. The department resisted
the application on the ground that though the legal ownership ostensibly vested with
the applicant, the real and beneficial owner of the capital gains was the US Company
which controlled the applicant. The applicant was merely a faade of the US holding
Company to avoid capital gains tax in India.
However it was held that there was no legal taboo against treaty shopping. It was
held that the underlying objective of tax avoidance/mitigation cannot be equated to a
colourable device. If a resident of a third country, in order to take advantage of a tax
treaty sets up a conduit entity; the legal transactions entered into by that conduit entity
cannot be declared invalid. The motive behind setting up such conduit companies is
not material to judge the legality or validity of the transactions. Tax avoidance is not
objectionable, if it is within the framework of law and not prohibited by law.
However, a transaction which is sham in the sense that the documents are not bona
fide in order to intend to be acted upon but are only used as a cloak to conceal a
different transaction stands on a different footing. As all legal formalities for the
purchase of the shares and their subsequent transfer had been completed, the
assumption that the capital gain had not arisen in the hands of the applicant but had
arisen in the hands of the USA parent did not hold ground. The fact that the holding
company exercised control over its subsidiary did not, in the absence of compelling
reasons, dilute the separate legal identity of the subsidiary. Thus, it was held that the
3E*Trade Mauritius Ltd [2010] 324 ITR 1 (AAR)

CAPITAL GAINS STRUCTURING


India-Mauritius treaty benefits could not be denied on the ground that assessee was a
subsidiary of US Corporation.
It can be concluded that to avail tax benefits under such a transaction one should route
the deal through tax neutral jurisdictions like Mauritius. This can be done through
layers of Investment subsidiaries in tax-free jurisdictions. Also, fanning the control
through multiple companies and not a nodal structure helps. In cases where a capital
gain incidence arise on a foreign company holding share in an Indian company, the
situation can be avoided and minimized by the following methods :
(a) By taking advantage of the relevant provision of Double Taxation Avoidance
Agreement (DTAA) if any entered between the foreign country and India.
(b) By not directly holding the shares in the Indian Company, but instead through
another investment company situated in any other foreign country where there will be
lesser incidence of capital gain tax.
(c) By setting up transnational subsidiaries in typical tax haven countries like
Mauritius where there is capital gain tax on the sale of movable property of a resident
irrespective of the size of the property.
These kind of smart investment structuring, as the one created by Vodafone, Google,
Facebook, help in avoiding large tax amounts in jurisdictions such as India where the
taxation rates are high and taxation laws are extremely stringent despite measures like
Double Taxation Avoidance and Advance Pricing.

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